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SEC finalizes broker-dealer/advisor Standard of Conduct rule

On June 5, 2019, the SEC, by a 3-1 vote, (1) finalized its “Regulation Best Interest” (RBI), providing new conduct standards for broker-dealers (hereafter simply “brokers”) making recommendations to retail customers, (2) published an “Interpretation Regarding Standard of Conduct for Investment Advisers” that “reaffirms – and in some cases clarifies – certain aspects of [an investment adviser’s] fiduciary duty,” and (3) finalized a new requirement that brokers and investment advisers provide retail investors a “Relationship Summary”–a standardized, short-form disclosure.

Significance for plan sponsors

The new rules are primarily of interest to investment professionals. They will, however, affect retirement plan sponsors in two ways: 

First, brokers, investment advisers, and their affiliates may serve as plan service providers, e.g., call center operators and participant advice and education providers affiliated with financial services firms. The RBI, particularly, will significantly change the standard of conduct rules for brokers and thus is likely to change how brokers and their affiliates interact with plan participants.

Second, sponsor retirement plan fiduciaries generally have a legal obligation under ERISA to monitor the conduct of plan service providers. That duty to monitor may extend to monitoring compliance with federal securities laws. Connecting the dots: under the RBI, the federal securities law requirements applicable to these retirement plan service providers (e.g., brokers/broker affiliates acting as call center operators) are significantly changed (indeed, increased); as a result, what plan fiduciaries must monitor is also changed (and conceivably increased).

We are providing two articles on the new SEC rules. In this first article we review the new standard of conduct rules for brokers (the RBI), focusing on how it will apply to broker interaction with plan participants. In our second article, after briefly reviewing the Investment Adviser guidance and relationship summary requirement, we will discuss how the new rules may affect plan fiduciary obligations.

Regulation Best Interest

The SEC’s Regulation Best Interest is less comprehensive than the “impartial conduct” standard and the contract, disclosure and pay policy standards under DOL’s Fiduciary Rule and related Best Interest Contract Exemption (BIC). Nevertheless, its provisions in many respects address similar issues – disclosure, standard of care and elimination or mitigation of conflicts – in a way similar to the approach taken by the DOL in the Fiduciary Rule and (especially) the BIC.

The RBI consists of two separate parts: an “overarching” general best interest obligation and four “component” obligations. 

General Obligation

The RBI general obligation requires that when a broker/affiliate makes a recommendation to a retail customer it must act in the “best interest of the retail customer …, without placing the financial or other interest of the [broker/affiliate] ahead of the interest of the retail customer.”

For purposes of this rule, “retail customer” is limited to natural persons (and their representatives) who use the recommendation “primarily for personal, family, or household purposes.” The rule covers participants in “workplace retirement plans” (e.g., 401(k) plans) but would not cover recommendations made to plan fiduciaries.

Component Obligations

To comply with the new rule the broker must also meet four “component” obligations:

1. Disclosure Obligation: The broker must, at or prior to the recommendation, provide “full and fair” written disclosure of (1) all material facts relating to the scope and terms of the relationship (including material fees and costs, the services provided, and any material limitations on the securities/investment strategies that may be recommended) and (2) material facts relating to conflicts of interest. 

2. Care Obligation: The broker must exercise reasonable diligence, care, and skill to: (1) understand the recommendation’s risks, rewards, and costs and have a reasonable basis to believe it could be in the interest of at least some retail customers; (2) have a reasonable basis to believe that the recommendation is in the best interest of the particular retail customer and does not place the broker’s interest ahead of the interest of the retail customer;(3) have a reasonable basis to believe (where applicable) that a series of transactions (viewed together and not in isolation) is in the retail customer’s best interest when taken together.

The SEC explained that the new Care Obligation “significantly enhances the investor protection provided as compared to current suitability obligations….” In that regard, “costs” were explicitly addedto the Care Obligation in the final rule, as a factor to be considered in forming the reasonable basis for a recommendation.

3. Conflict of Interest Obligation: The broker must establish, maintain, and enforce written policies and procedures reasonably designed to: 

(A) Identify and disclose all conflicts of interest associated with a recommendation.

(B) Identify and mitigate any conflicts that “create an incentive for a natural person [affiliated with the broker] to place the interest of the broker… or such natural person ahead of the interest of the retail customer.” In English: the brokerage firm must mitigate conflicts (e.g., financial incentives) that encourage affiliated individuals (e.g., a call center operator) to put her or the firm’s interests ahead of the retail customer’s interest.

(C) (i) Identify and disclose any material limitations on the securities/investment strategies that may be recommended and any conflicts associated with those limitations, and (ii) prevent those limitations and conflicts from causing recommendations to be made that place the interest of the broker (or an affiliate) ahead of the interest of the customer. Thus, where the recommendations that a broker/affiliate may make are restricted (e.g., to proprietary products), the firm must make the “global” determination that those restrictions do not effectively prevent recommendations that are in the customer’s best interest. 

(D) “Identify and eliminate any sales contests, sales quotas, bonuses, and non-cash compensation that are based on the sales of specific securities or specific types of securities within a limited period of time.”

4. Compliance Obligation: The broker must maintain and enforce written policies and procedures reasonably designed to achieve compliance with the RBI.

Effective date

Under a transition rule, firms must generally comply with the RBI beginning June 30, 2020.

Issues relevant to retirement plans

In connection with the RBI, the SEC published a 763-page explanation that discussed a number of issues relevant to retirement plans:

Application of the RBI in the rollover context

“Recommendations” covered by the rule include “account recommendations including, among others, recommendations to roll over or transfer assets in a workplace retirement plan account to an IRA … and recommendations to take a plan distribution for the purpose of opening a securities account.” Thus, the RBI will cover any recommendation by, e.g., a broker-affiliated call center operator that a retiring participant roll her plan assets into an IRA. “Recommendations” would also generally include a recommendation to take a plan distribution or plan loan. 

In discussing how the broker’s “Care Obligation” would apply to a recommendation in the rollover context, the SEC stated:

Regulation Best Interest also applies to recommendations to open an IRA or to roll over assets into an IRA. Thus, the Care Obligation will require a broker-dealer to have a reasonable basis to believe that the IRA or IRA rollover is in the best interest of the retail customer at the time of the recommendation and does not place the financial or other interest of the broker-dealer ahead of the interest of the retail customer, taking into consideration the retail customer’s investment profile and other relevant factors, as well as the potential risks, rewards, and costs of the IRA or IRA rollover compared to the investor’s existing 401(k) account or other circumstances.

When making a recommendation to open an IRA, or to roll over workplace retirement plan assets into an IRA rather than keeping assets in a previous employer’s workplace retirement plan (or rolling over assets to a new employer’s workplace retirement plan), broker-dealers should consider a variety of factors, the importance of which will depend on the particular retail customer’s needs and circumstances. In addition to the Factors to Consider Regarding a Recommendation to a Particular Retail Customer discussed above, as well as the Retail Customer’s Investment Profile, broker-dealers should consider a variety of additional factors specifically salient to IRAs and workplace retirement plans, in order to compare the retail customer’s existing account to the IRA offered by the broker-dealer. These factors should generally include, among other relevant factors: fees and expenses; level of service available; available investment options; ability to take penalty-free withdrawals; application of required minimum distributions; protection from creditors and legal judgments; holdings of employer stock; and any special features of the existing account.

The critical importance of the retirement/rollover decision

With respect to the Compliance Obligation, the SEC stated that:

As a best practice, firms also should encourage their associated persons to discuss the basis for any particular recommendation with their retail customers, including the associated risks, particularly where the recommendation is significant to the retail customer. For example, the decision to roll over a 401(k) into an IRA may be one of the most significant financial decisions a retail investor could make. Thus, a broker-dealer should discuss the basis of such recommendations with the retail customer. [Emphasis added.]

General information about plan rules not covered

The SEC stated that “general communications by [brokers] relating to distributions in the context of a required minimum distribution or education regarding a plan’s options” would not be “Recommendations” and thus would not be covered by the rule. Nor would “a general conversation about retirement planning” or informing a participant that she must take a required minimum distribution.

*     *    *

The new rule is likely to have a significant effect on broker conduct. Plan sponsors will want to review with broker-related service providers whether and how the new rule will affect the services they provide.

The new rule – and possible additional and related guidance from DOL – may also affect plan sponsor fiduciary responsibilities, critically the extent of plan fiduciaries’ duty to monitor compliance with the new rule. We will consider that issue in detail in our next article.

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